How do you generate a return of more than 200 per cent from Japanese small-caps when the index is barely making 60 per cent and the main market is tumbling? By investing in the most important companies you’ve never heard of, says Praveen Kumar, manager of Baillie Gifford Shin Nippon (BGS). He is investing in Japan’s best-kept secret – a new generation of entrepreneurs poised to take business from the nation’s biggest companies.
Mr Kumar took over management of IC Top 100 Fund Baillie Gifford Shin Nippon in December 2015, which under previous manager John MacDougall chalked up some very strong numbers: over 10 years it has returned 81.6 per cent against 31.8 per cent for MSCI Japan Small Cap Index, and over five years 212.7 per cent against 61.1 per cent for its benchmark.
Mr Kumar plans to ensure the trust continues to soar above its index and rivals by investing in small and under-researched stocks that play a crucial part in some of the most exciting areas of the global market. Headlines about Japan conjure images of a slowing, lumbering giant of an economy struggling to turn itself around despite best fiscal efforts, but he says that further down the market scale something more exciting is happening – and he has the proof.
“In Japan there are a number of industries that remain quite traditional, where vast profit pools are still controlled by really big, sleepy, slow-moving incumbents, and there are also a lot of inefficiencies across a number of sectors because the country has traditionally had a lot of layers of distribution and supply,” he says. That is what I refer to as the ‘old Japan’.
“But we are seeing a number of young companies developing creative and destructive business models, most of them using the internet as a tool to create disruption, and these young companies are attacking the more established businesses quite aggressively,” he says.
Baillie Gifford Shin Nippon invests in companies under a market cap or sales threshold of ¥150bn (£973.39m). These stocks offer the potential for enormous growth and, crucially, are also under-researched by the market, making them a key area for the manager.
“Typically in Japan the number of analysts covering these smaller companies is quite low. For 40-60 per cent of stocks listed on the Tokyo Stock Exchange the average number of analysts is 1.5 and further down the market-cap scale it is nearer zero,” he says.
Mr Kumar is looking for a new wave of disrupting companies with the power to dislodge the major, well researched players with no growth prospects. New holding Nippon Ceramic (TOK:6929) is a key example. You may never have heard of it, but the small Japanese company has 50-60 per cent of the global market in crash avoidance sensors used in one of the most-talked about industries of the future – driverless cars– and has a 90 per cent market share of this in Japan. The stock accounts for 1 per cent of Baillie Gifford Shin Nippon’s assets.
New holding Bengo4.com (TOK:6027), an online legal services company, and ecommerce industrial supplier MonotaRO (TOK:3064) - the trust's largest holding - have a risk-taking, entrepreneurial culture which is a direct contradiction to ‘old Japan’, he says.
“Risk taking and entrepreneurship in Japan has traditionally been looked down upon because of an embedded culture of jobs for life, but now we are seeing the initial signs of that culture slowly shifting,” explains Mr Kumar. “Risk taking and entrepreneurship is becoming more and more accepted, and a number of young dynamic entrepreneurs are emerging.”
The biggest challenge of investing in smaller companies might turn out to be holding on to them. Since investing in MonotaRO in 2009 the stock has gone up 50 times in sterling terms, while pharmaceutical stock M3 (2413:TYO), which has been in the portfolio for 10-11 years, has gone up 18 times.
Making strong returns is good, but is this trust still a genuine small-cap fund? Over 20 per cent of the trust is now invested in Topix Mid 400 stocks, and Mr Kumar’s sell discipline is not based on stock size but growth potential, meaning it could feasibly hold on to stocks far beyond the market cap they started out at in the portfolio.
“Our sell discipline is just a case of how much conviction we have remaining in terms of the growth opportunity,” he says. “If I believe that a company has maxed out its opportunity and from here on is likely to grow at a more mature pace, there might be a case for rethinking the position of that company in the portfolio. But for a stock like MonotaRO, although in market cap terms it is big, in sales terms it is still below ¥150bn and continuing to grow rapidly, so I’ve got no problem holding on to it.”
Mr Kumar refuses to be drawn on how the (admittedly major) macro headwinds facing Japan will affect his stocks, claiming that he deliberately chooses stocks that are fundamentally strong enough to survive volatile periods. But he says the Japanese stocks to back will not be the well-known incumbents.
“These national champions that had previously been a big asset for Japan are now almost becoming a bit of a liability in that they are preventing creative destruction and entrepreneurialism emerging much further than it has.”
So for double-digit returns smallers might be the way forward.
